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< Back to current issue of Immigration Daily < Back to current issue of Immigrant's Weekly

The Internal Revenue Code And The Foreign National – Three Fundamental Mistakes

by George J. Hayduk, Esq.

The Internal Revenue Code can apply to transactions occurring years, even decades, prior to becoming a US Tax Resident, many poorly advised aliens miss the tax planning opportunities present here.

Having advised expatriates on the international provisions of the Internal Revenue Code (“I.R.C.) for over 15 years, I have seen three fundamental mistakes routinely arise. First, the alien all too often resorts to home country tax principles that may differ significantly from US tax principles (unfortunately, networks of fellow expatriates often become their tax advisors). For example, many foreign tax laws intentionally do not reach “offshore income”, say, a financial account in a tax haven. That is not the case under the worldwide reach of the I.R.C. This mistake often results in unreported income, penalties for failure to file offshore bank account information forms, and can amount to tax fraud. The IRS recently cracked down on the use of offshore credit cards used in connection with these accounts. In addition, the US Treasury is increasingly using exchange of information agreements or tax treaties to gather foreign tax information even from tax havens.

The second mistake is a practical one. Many aliens do not have the luxury of the typical corporate transferee who is likely to have an experienced international tax accountant or lawyer at his beck and call. Of course, the young and the poor without serious assets abroad have little need for international tax advice, but there is that middle segment who may have complex assets abroad but who are not handed international tax advice. These aliens are the ones likely to make the second mistake. They go to a local tax accountant or use retail tax software. It is highly unlikely that either will have the capability to deal with international issues. If the aliens overseas assets are limited to a financial account and similar simple assets he may not need international expertise; however, if his assets include pensions, real estate, trusts, or closely held companies, he will need international expertise.

The third mistake is the failure to understand the temporal reach of US tax law and this is the focus of the remainder of this article. I will address pensions and real estate as those are the assets most likely to be held by this group. 

Foreign nationals often assume that US tax principles start their application when the foreign national first enters the US tax net by becoming a US tax resident (the 183 day physical presence test or lawful permanent residence status) or by realizing US source income. That is incorrect.

As stated by noted international tax scholar Joseph Isenbergh, “ the US tax system assigns tax attributes as though foreign assets have been subject to US taxation along” [1]. In effect, there is a notional application of the US tax system to all the world’s economic transactions, and that notional application has real effect when those assets enter into the US tax net, typically when their owner becomes US tax resident. 

The most important tax attribute of assets is “basis”, the unrecovered amount invested in an asset from which gain or loss is measured. For example, under US tax principles the basis of an asset inherited many years ago will be restated to its fair market value at the time of the owners death, even if the decedent and his heir both resided in Central Asia at the time of death. If the same asset were transferred in a like-kind exchange (determined under US tax law, our carryover basis rules would apply, and there would be no restatement to fair market value. 

Many transactions may be tax-free under home country laws but taxable under the Internal Revenue Code. In such case, a transaction entered into well before entering the US tax net may result in the recognition of income or gain (and most importantly, a “step-up in basis” even if never subject to actual US taxation), even if that is not the case for purposes of home country tax. For example, a transfer to a corporation in 1990 may be tax free at home but taxable under the IRC, and when the owner of that corporation brings it into the US in 2005 the appreciated property may get a “step up in basis”, never to be taxed on that gain, when sold as a US tax resident.

Another example would be employer pensions established under foreign tax legislation. These plans will not satisfy the technical requirements of I.R.C., [2] Therefore, notwithstanding qualification under foreign law such plans are nonqualified for purposes of US tax and their taxation are governed by I.R.C. provisions that govern taxation of nonqualified retirement schemes.[3] Employer contributions to those plans while the alien is nonresident for purposes of US tax represent income earned in those years and therefore becomes “basis” or “investment in contract” for purposes of the annuity rules under the I.R.C. [4] The foregoing conclusions have been accepted by the IRS in a long-standing revenue ruling. [5]

Therefore events occurring years even decades prior to coming to the US are extremely relevant in determining the proper taxation of current pension distributions under the I.R.C.[6]

Conclusion

If the alien thinks his tax treatment of a particular position is correct because he did it that way back home or his personal network of fellow expatriates say it is correct, he should think again. If he is reporting the US tax consequences of a fairly complex foreign asset, he should ask his tax advisor how often he or she deals with complex international matters. If the answer is not satisfactory, he should move on. Finally, the foreign national should be prepared to document the history of assets as he or she will have the burden of proof if challenged by the IRS. Therefore bring the appropriate records with you to the US.


Footnotes

1 Joseph Isenbergh, International Taxation, p. 16.6 (1998)

2 I.R..C. Sec. 401(a) and Sec. 501.

3 IRC Sec. 402(b) “Taxability of Beneficiary of Non-exempt Trust”.

4 IRC Sec. 72(f)(2) restates the principle noted above by providing if employer contributions had been paid directly to the employee and they would not have been includible in gross income under law applicable at the time of contribution then they shall be included in “investment in contract”. This is exactly what happens to an alien working outside the US.

5 Revenue Ruling 58-236.

6 The analysis becomes a bit more complicated as the recent trend in tax treaties is the notion of “corresponding approval” of pension plans, wherein the tax authorities of treaty partners accept each others plans as mutually qualified but only in limited circumstances. See Articles 17 and 18 of US-UK Tax Treaty. In addition retirement schemes arising in a number of countries are unfunded or “pay as you go” type plans wherein the rules discussed above will not apply. These types of plans are likely to be found in France and Germany.


About The Author

George J. Hayduk, Esq. practices immigration law in Connecticut. Previously, he practiced international tax law for over 15 years primarily involving international pensions, trusts, and complex tax treaty matters. He can be reached through his website www.hayduklaw.com


The opinions expressed in this article do not necessarily reflect the opinion of ILW.COM.


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